Disruptive technology

Banking, Bitcoin, and blockchain—win-lose-lose or lose-win-win?

In the long run, which will be the bigger B? Will the banking industry do to blockchain, and thus to the soul of Bitcoin, what in recent years it started doing to feeble fintech operators: acquire challengers and digest unwanted competitors before they can threaten legacy players? Or will the blockchain bacterium lead to a total mutation of the entire banking sector to the point that the banking business models of 20 or 100 years from now would be unrecognizable for today’s bankers?

“Cryptocurrencies could possibly be the single most disruptive technology to global financial and economic systems” by virtue of the fact that current financial and legal structures were designed with a completely different mindset and purpose, wrote Peter DeVries, a professor of information systems at the University of Houston in Texas, in an article published in September 2016 in the International Journal of Business Management and Commerce. “If cryptocurrencies became the global norm for transactions, long-standing systems for trade would need to be completely reformed to deal with this type of competition,” he stated in the introduction to an analysis of Bitcoin and cryptocurrencies.

The academic’s view is not spectacular in itself, given that the birth of Bitcoin at the height of the great recession of 2008 and 2009 appears to have been anything but a coincidence. The author, or authors, of the original white paper published under the pseudonym Satoshi Nakamoto “addressed a very serious question: If the banking system and central banks were not able to avoid such a big crisis, is there something we can do?” says Henri Azzam, director of the Master of Finance program at the Olayan Business School of the American University of Beirut. “The whole idea was to come up with a payment, clearing, and settlement system which is decentralized, rather than centralized in the way of going through banking or going through central banks.”

By this description, one of the roots of Bitcoin was the global financial crisis, and the desire—boosted by a historic economic crisis that was spurred by rampant mismanagement in the financial industry—to develop a payment system that would not fail the world. The targets of Bitcoin anarchists’ greatest disdain (besides governments and central banks), unsurprisingly, are commercial banks of all flavors. Moreover, it is the conventional wisdom of the period after the great recession that the systemic faults underpinning the freezing of financial liquidity in 2008 and 2009 were at best partially remedied. It, therefore, becomes more understandable when critics of current monetary affairs hail the importance of digital currency alternatives, such as when Jim Rickards—who wrote the books Currency Wars (2011) and The Death of Money (2013)—said that Bitcoin’s “widespread adoption can be taken already as a sign that communities around the world are looking for alternatives to the dollar and traditional fiat currencies.”

Given the clear intentions of decentralization and change in the global order of money, plus numerous signals that the financial and banking sector is likely to experience both, the first and the largest disruption comes from the rise of everything crypto. It is curious that international bankers and their institutions tend to come down on both sides of the debate over cryptocurrency. Sometimes bankers have even had to make an about-face turn after a rash statement, such as the infamous “Bitcoin is a fraud” remark of September 2017 by Jamie Dimon, the chief executive of JP Morgan Chase, the largest multinational bank headquartered in the United States. (He came out in January to say he “regretted” his fraud remark.)

Bulls and bears

More concerning than Dimon’s one-eighty was that he was on record telling Fox News in the same interview, “I’m not interested that much in the subject at all.” In another example of emotional dissociation with the cryptocurrency challenge, this one from a prominent European bank, Credit Suisse CEO Tidjane Thiam was quoted by Reuters as telling a news conference last November, “I think most banks in the current state of regulation have little or no appetite to get involved in a currency which has such anti-money laundering challenges.”

According to a selection of quotes from central bankers, bankers, noted investors, and fund managers compiled by Bloomberg under the heading Bitcoin Bulls and Bears, bears outnumbered bulls about two to one in the 30-plus comments recorded since March 2017. However, the majority of statements avoided total clarity or a great passion for cryptocurrency. Almost all the quotes, whether from bulls, bears, or people leaning toward neutrality, focused on short-term issues, mainly giving opinions about the present Bitcoin and dotcoin bubble phase, and the related potentials for gain or loss.

The real question about the current state of relationships between banks and cryptocurrencies may not hinge on people’s word choices, but rather whether established financial professionals and banking executives are paying enough attention to this issue. Comments in this direction seem to be rare, with a statement by International Monetary Fund Chief Christine Lagarde from last September one of the exceptions. “Virtual currencies are in a different category [from digital payments in existing currencies], because they provide their own unit of account and payment systems,” she told a Bank of England conference then. The existing weaknesses and technological challenges of virtual currencies such as Bitcoin could well be addressed over time, and “it may not be wise to dismiss virtual currencies,” she said, advising the conference-goers “to think of countries with weak institutions and unstable national currencies,” of which some might see a growing use for virtual currencies.

It seems indeed prudent for banks to prepare for the eventuality that cryptocurrency will turn out to be more than just a favored narrative of economists on the anarcho-capitalist fringe and an obsession of a bunch of crypto weirdos who flash their cyber implants at nerdy events. If cryptocurrency is not just a new technology hype that is exploited by mongers of greed, fear, and assorted crimes, polite disinterest from mainstream economists and financial influencers is not a promising approach—especially as no one can rule out that the next financial emergency could be in the making, while elites in the US congratulate themselves about their genius tax reforms, and international elites celebrate the current “synchronized momentum” of the global economy.

It seems that the best many global banks can say for themselves in relation to the cryptocurrency discussion is that they are members in groups dedicated to the development of distributed ledger variants that can be of use to the financial industry. Blockchain associations go by a confusing number of names with a broad range of targeted industries, such as Wall Street Blockchain Alliance (WSBA) for Wall Street firms in New York City, the Blockchain in Trucking Alliance (BiTA) for the logistics industry, or the more recently Blockchain Interoperability Alliance founded by specialized tech companies to construct a global interconnected network of blockchain protocols. Some blockchain clubs are more in the sights of banks, such as the Linux Foundation’s Hyperledger Project, whose members include Wells Fargo, ABN Amro, China Merchants Bank, BNY Mellon, and BNP Paribas; the one-year old Ethereum Enterprise Alliance (EEA), whose members include UBS, Credit Suisse, Santander, ING, Scotiabank, and JP Morgan; and the R3 CEV consortium, which claims to serve over 100 financial institutions and regulators. R3 was established with the participation of major banks in 2015 and aims to serve the needs of banks and the financial industry with its Corda blockchain platform.

These initiatives and their cousins in the academic and non-profit space, such as the UK-based Blockchain Alliance for Good (bisgit), do not presently appear to attract the sort of attention that Bitcoin and altcoins get due to their price trajectories and, as LAU professor Saifedean Ammous emphasizes in the manuscript of his upcoming book, so far have nothing much to show that actually works. But at least they exist.

Although scores of banks are in one global blockchain club or other, no Lebanese bank appears to be on any such alliance’s membership roster, nor do local bankers radiate with willingness to go on record with cryptocurrency opinions. Anecdotal evidence gathered by this writer since autumn 2015 during official interviews and off-record chance encounters with bankers, as well as industry conversations and info bytes shared with Executive, all betray a great silence. Given the size and importance of this global, albeit young, debate, it seems almost unnatural how little local bankers have to say on the matter, other than making reference to the stance of the central bank and citing a handful of comments by Governor Riad Salameh.

One exception to this blast of silence in the local banking intelligentsia is AUB’s Azzam, who is a regional banking veteran. In an interview with Executive, he readily outlines his views on Bitcoin and his take on the role of blockchain and cryptocurrencies in relation to banking. The central question on Bitcoin to him is its nature and role in the economic system. “The big question is if Bitcoin is a currency—and I argue no, is it an asset—what is left is [the question]: Is Bitcoin a speculative bubble? And I will argue yes,” he says.

Asset or currency?

He then elaborates on definitions and required characteristics of a currency, namely being used as unit of account, useful as store of value, and of broad practicality as means of exchange. Denying all three uses and pointing out that Bitcoin today is far too expensive to use as a medium of exchange, he goes on to discuss the character of an asset under conventional economic definition. For something to be considered an asset, it should generate a cash flow or the prospect of a cash flow as well as facilitate the determination of its fair value. In his view, nobody can think of a fair value of Bitcoin. “Only for an asset with a cash flow or the promise of a cash flow can you come up with a fair value. It is therefore not an asset and not a currency. It is something that people are buying for only one reason: because they expect the price to go up,” he says, explaining that is the very definition of a bubble.

Azzam says the best way to describe Bitcoin is “digital gold,” yet he asks, rhetorically, “But what does this mean?” He also acknowledges its scarcity by design, but argues that scarcity by itself does not necessarily signify value. The fact that something is rare—for example, a signed photograph of someone who is famous in your family but unknown on any larger scale—will not translate into market value unless there is someone who is willing to buy it. “Human beings, of course, have created value out of nothing throughout history, but to create value, but you need someone who is willing to pay for it. The market creates value,” he says.

According to Azzam, the issue of control over the mining process and the concentration of Bitcoin capital could be more important than Bitcoin’s pre-determined scarcity (21 million coins, each with 100 million sub-units known as satoshis). “What Nakamoto wanted was a decentralized ledger, [later named blockchain], that was permission-less, so that everyone can go and be an active miner on the distributed ledger,” he says. But what ended up happening, Azzam says, was the opposite of decentralization. Because of the mix of increasing costs of mining due to predesigned and incremental increases in the amount of computing power needed to mine a coin and a resulting combo of growing hardware and electricity costs (mainly for cooling the CPUs in a mining facility), “It costs a lot of money today to validate a transaction [on the Bitcoin blockchain]. Thus only the big guys are today able to continue playing the game. So we started with decentralized and ended up with 100 whales who actually control all of this as miners,” he explains, questioning whether this will lead to monopolistic or oligopolistic cartel behavior of a small group instead of decentralization and democratization.

Only fools rush in

The time-tested method of seeking to counter oligopolies and remedy imperfect competition in markets is regulation from outside, but this hardly agrees with the design of a completely decentralized blockchain and the rejection of governmental authority. For Azzam this is where the story of Bitcoin goes off the rails and the story of blockchains takes over. “The whole story of Bitcoin, in my view, is the blockchain, and the fact that there is use for a blockchain,” he says, pointing to the concept of a central bank-issued digital currency and its advantages as a supplement for existing money: the potential to expand financial inclusion of the unbanked population, the efficiency of instant clearing, and the reduction of transaction costs in financial systems. “We are looking [at] how to use these advantages by using the central-bank digital-currency idea,” he says.

This would not affect commercial banks in their lending activity and management on behalf of customers, but it would alter their role as facilitators of payments. By implementing a central bank-issued digital currency and creating digital wallets that will be hosted by central banks, commercial banks “will realize that they are not making as much money and don’t need as many branches and as many ATMs. This will definitely disrupt the banking sector, but on the side of payment,” Azzam says, suggesting this would necessitate a revision of strategies for retail networks and require a further evolution of banks, not only because of the arrival of digital currencies but also because of other much-discussed fintech innovations, from crowdfunding to robo-advisors and even initial coin offerings in the crypto realm. “Banks have to be ready for all of those challenges. They cannot say that they will be doing business as usual, because the writing is on the wall—business will not be as usual,” Azzam emphasizes.

Pointing to countries such as Sweden, where mobile and internet transactions are already market dominant and bank branches are closed or redesigned to be cashless, and emerging economies such as China and India that are pushing forward in similar directions, he adds that banks in Lebanon are “aware and talk about it in our board meetings, but the perception is that this is not happening tomorrow, so we have time. Banks here think they can continue doing what they are doing.”

Denial of new technology can be a dangerous game, and high-profile central-bank initiatives toward the creation of digital currencies, in Azzam’s view, would force banks to be more serious about the issue. He also notes, however, that there are strong reasons why central banks would take their time in unleashing the digital currency shift, even as they regard it as the future. They are unlikely to rush into any partial conversion of reserves into Bitcoin, for example, because central banks are not in the business of speculation. They might also take more time than technically required in launching their own digital currencies, because huge disruptions of banking structures through abrupt deployment of citizens’ e-wallets at central banks and the reduction in numbers of current accounts at commercial banks would result in survival challenges for many of these banks.

With all this, a lose-win-win result of the cryptocurrency challenge to banks seems somewhat unlikely. A potential outcome of the banking-Bitcoin-blockchain game scenario could be win-lose-win, if it does not come to a perfect non-zero-sum game of win-win-win for all three. But according to Azzam, there seems to be no way that banks could achieve a win-lose-lose and wiggle out of embracing some type of distributed ledger system. This modified distributed ledger system, he says, “is a different kind of blockchain that is faster and efficient. It is an instant-clearing payment system, which we don’t have now, and it is the technology of the future. It is post-internet and we need to be ready for it.”